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Szablewski the need_for_revaluation

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YEARBOOK Peer-reviewed scientific periodical, of ANTITRUST focusing on legal and economicand REGULATORY issues of antitrust and regulation. STUDIES Centre for Antitrust and Regulatory Studies, Creative Commons Attribution-No University of Warsaw, Faculty of Managementwww.yars.wz.uw.edu.pl Derivative Works 3.0 Poland License. www.cars.wz.uw.edu.pl The Need for Revaluation of the Model Structure for Electricity Liberalization Andrzej T. Szablewski*CONTENTS I. Introduction II. The origin of the fully unbundled concept III. Restructuring developments IV. EU unbundling initiatives V. The first signs of crisis in the restructuring canon VI. Concluding remarks Abstract The question about an appropriate structure for the electricity industry has been extensively discussed in scientific literature and experts studies. Since the beginning of electricity liberalization, it was apparent for its promoters that such a structure (in this paper referred to as the model structure or ideal structural model) for the electricity sector should involve a separation of its four sub-sectors, i.e., generation, transmission, distribution, and supply. With the exception of transmission, each sub-sector should consist of many stand-alone type companies. Given the high degree of vertical and horizontal integration of the electricity sectors, their pro- competitive restructuring (i.e., de-integration) became a standard component of electricity sector reform packages. This paper provides a concise review of the origins and justification of the initial model structure for electricity liberalization, as well as an overview of the restructuring developments in the early years of electricity liberalization. Some attention is also devoted to the EU’s unbundling initiatives. The core part of this paper discusses the first signs indicating the crisis of the initial structural canon. The paper concludes with some comments referring to the modified form for a model structure that is emerging. It involves vertical integration of generation and supply and allows a higher degree of horizontal concentration of the electricity competitive markets. * Prof. Dr. Andrzej Szablewski, Professor of economics at the Institute of Economic Sciences,Polish Academy of Sciences.Vol. 2011, 4(4)

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 203the development and effective operation of competitive markets as wellas in introducing regulatory mechanisms in those parts of each networkindustry where features of a natural monopoly still dominated, makingeffective competition impossible. For promoters of the network industries’liberalization, it was apparent that the restructuring component should involvevarious activities and efforts leading to vertical and horizontal de-integrationof these industries. In the case of the electricity supply industry, its idealstructure model involved separation of the four sub-sectors, i.e. generation,transmission, distribution, and supply, with numerous stand-alone typecompanies within each of these sub-sectors (excepting transmission, whereonly one national-wide company was to operate). In the 1990s the above modelbecame a recommended part of market-oriented reforms in other developedand developing countries. Despite strong beliefs in its rationality and the increasing support of theEuropean Commission for such a structural transformation of the electricityindustry, the real structural changes that followed did not occur in therecommended direction. First of all, the restructuring component did notbecome a part of the liberalization reforms in a number of countries. Moreover,instead of the gradual de-monopolization that should accompany developmentof the electricity liberalization, the structural evolution of the electricity sectorhas in fact been going in the opposite direction. Since the end of the 90s,the pace of the industry’s consolidation has been rapidly increasing. Throughnumerous mergers and acquisitions, the electricity industry has become morehorizontally and vertically integrated than it had been prior to liberalization. However, the most remarkable indication of this trend (opposite to whatmost experts had recommended and expected at the time when electricityliberalization was launched) were the cases of vertical and horizontalreintegration taking place in the industries that had earlier been restructured inline with the structural canon. This was particularly visible in the UK, whencethe structural canon had originated. In the light of this reverse direction of thestructural developments in the European electricity sectors a very importantquestion arises. It concerns the reasons for the retreat from this structuralcanon. The answer to this question has recently become the subject of livelydiscussion and controversy. The central issue is whether a growing degreeof vertical and horizontal integration in the electricity industries resultsfrom (a) failure of the public and governmental organs responsible for theimplementation of structural and competition policies to resist the pressures ofthe sector’s vested interests to rebuild or strengthen the vertical and horizontalties, and/or (b) the political will to establish national champions based on hopesthat such entities will be better prepared to ensure the security of electricityVol. 2011, 4(4)

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204 ANDRZEJ T. SZABLEWSKIsupply and to compete in the European electricity market, or (c) other factorswhich did not receive sufficient attention when the concept of market reformswas in the developmental stage. This paper focuses on option (c). Although it would be inappropriateto fully ignore the first and second options, there is an increasing numberof arguments for a more nuanced approach to the issue of the electricityindustry’s structure, especially to the model for the stand-alone electricitycompany. This approach is based on the assumption that the consolidationtrend should not be interpreted as a process determined only by the vestedinterests of incumbents (and ipso facto not acceptable in terms of economicefficiency and interests of electricity consumers), but also as a form of rationaladjustment of the electricity company model to the conditions imposed onand challenges created by competitive electricity markets. Moreover, in thelonger term this adjustment can also benefit electricity customers, as well asbe conducive to the strengthening of electricity supply security. It is worth stressing that the issue of the electricity company model can beconsidered not only in a theoretical, but also in a practical context. The formerputs the discussion on the correctness of the structural canon in a broaderperspective involving barriers that may implicate the existence of limits fordevelopment of the competitive electricity markets. The latter refers to thetargets of regulatory and competition policies. In the previous decade manycountries targeted their policies at supporting market-oriented reforms inthe electricity sectors. The visible form of these policies was active, thoughoften not effective resistance to the consolidation pressure as it happenedin both the UK and Poland. The most important conclusion of this paper isthat the failure of the efforts to stop the consolidation process needs to bediscussed and assessed from a wider perspective, one that should not confinethe choice of industry structure to two extremes, i.e., full de-integration andfull integration. The paper starts with a short review of the origins and justification of theinitial model structure for electricity liberalization as well as some discussionon the reality of the restructuring activities in the 90s. Attention is devotedto the EU unbundling initiatives. The core part of this paper discusses thesigns indicating the crisis of the initial structural canon. Finally, the paperincludes some comments referring to the modified form of the model structurethat is emerging. This involves the vertical integration of generation andsupply and allows a more horizontal concentration of electricity competitivemarkets. YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 2052. The origin of the fully unbundled concept In order to understand why promoters of electricity liberalization attachedgreat importance to the restructuring component of such reforms, it is worthexamining the peculiarity of the electricity sector liberalization as along withother network-based sectors like gas, water, railways, and, until not longago, telecommunication. Said peculiarity results from the fact that each ofthose sectors is a combination of strictly interrelated types of activities outof which only some are potentially competitive1. The potentially competitiveactivities include electricity generation and supply (wholesale trade and retailsale to final consumers). Both activities represent two ends of the electricityproduction-service chain. In the middle of this chain there are two network-based activities – transmission and distribution. As the network activitieshad, and still have, natural monopoly features, and could not be regulated bycompetition forces, it became obvious that they had to be subjected to someform of public regulation. This, and the fact that the previous reforms in these sectors had not achievedthe planned effect, made it clear for policy makers and reform designers that thereform package could not be confined to the deregulatory measures that hadproved sufficient for a spontaneous and quick development of truly competitivemarkets in the earlier liberalizations of non-network-based industries. Thus,to achieve a key goal of liberalization, i.e. a decrease in the costs and pricesof electricity generation and supply, more complex reform programs weredesigned and implemented in 1984 in respect to telecommunication, andthen in 1986 in respect to the gas sector (1986). The reforms consisted ofthree main components: (i) privatization of the vertically and horizontally-integrated incumbents, i.e. British Telecom and British Gas respectively, withthe aim to make them more responsive to market and regulatory incentives;,(ii) deregulation of access to the telecommunication and gas markets to enabledevelopment of competition; and (iii) implementation of an innovative typeof economic regulation. The last component embraced the two main categories of regulatoryactivities: price regulation and promotion of competition. The novelty of theBritish type of price regulation consisted in the replacement of a model wellestablished in the private network industries for rate of return regulationwith a form of incentive regulation, widely known as an RPI-X2. The second 1 For more on liberalization and introduction competitive and regulated markets in thenetwork-based industries see: D. Helm, T. Jenkinson (eds.), Competition in Regulated Industries,Oxford University Press, Oxford 1994. 2 Abundant literature has developed on the issue of incentive regulation in general as wellas the RPI –X type. See in Polish: A.T. Szablewski, Zarys teorii i praktyki reform regulacyjnychVol. 2011, 4(4)

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206 ANDRZEJ T. SZABLEWSKIcategory of regulatory activity was innovative in itself, since the promotion ofcompetition – also through encouraging new entries – was not a standard partof the previous regulatory regimes. Moreover, the most advanced traditionalmodel of the United States’ utility regulation was in fact designed to protectincumbents from competition and thus, not surprisingly, it had a long recordof resisting new entries. The decision to include the promotion of competition into the list of statutoryduties of the British regulators was based on the assumption that competitionin network industries could not occur and quickly develop without a sectorregulator actively encouraging it. Two factors were determined as to why thetelecommunication and gas regulators were made responsible for promotion ofcompetition. The first was the evident failure of the British network industries’earlier reforms, dating to the beginning of the 1980s. Following the success ofthe liberalization of a number of the non-network-based sectors, these reformshad also been confined to only allowing newcomers access to the incumbentnetworks. The second – much more important – factor referred to the fact that theprivatization of both incumbents was not to be accompanied by their pro-competitive restructuring. As a result, they had been privatized as singleentities having 100% of the telecommunication and gas markets respectively.This happened despite strong recommendations, especially in the British Gascase, for breaking them up. However, despite facing fierce resistance fromBritish Gas, the British government decided to abandon its restructuringplans3. Therefore, in order to avoid repetition of previous failures in developingcompetition in highly concentrated markets, the Government expandedthe list of the regulators’ duties by adding an obligation to actively supportdevelopment of competition through the use of a regulatory weapon. Unfortunately, despite the vigorous efforts of regulators in both sectors,progress in promoting competition during the first years of their liberalizationwas rather slow. Moreover, the measures used by the regulators to facilitatenew entries raised serious controversy over their economic rationality4. Therewas also one more factor that made the policy makers more determinedto precede the privatization of another utility sector, i.e. electricity, with arestructuring of the biggest, vertically-integrated incumbent. This was thena przykładzie energetyki, Monografie Nr. 12 Instytut Nauk Ekonomicznych PAN, DiG Łódź-Warszawa 2003, rozdz. 5. 3 For more details on the recommended options for restructuring British Gas see: J. Vickeresand G. Yarrow, Privatization: An Economic Analysis, The MIT Press Cambridge, London, 1988,pp. 268–271. 4 For more on this see: A.E. Kahn, The Economics of Regulation. Principles and Institution,The MIT Press, Cambridge, Mass. 1990, p. XXXIV. YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 207growing awareness of the nature of threats resulting from maintaining thevertical structure of privatized incumbents untouched. As the cases of bothearlier privatized incumbents demonstrated, their vertical structure made itpossible for them to use a well known cross-subsidy tool, one broadly appliedin the network industries prior their liberalization, to prevent newcomers fromentering the potentially competitive markets5. Cross-subsidy is a kind of improper, in economic terms, assignment ofcosts among different activities that may also be easily utilized by a vertically-integrated incumbent to place potential entrants at a competitive disadvantage6.In practical terms, for a vertically-integrated company it is only an internaltransfer of costs from one activity to another. It enables the integrated companyto use profits from its monopoly operation to cover the costs of competitiveoperation. However, from the perspective of its potential competitors, thistype of cost-accounting system provides a vertically-integrated company withan opportunity not only to overcharge their potential competitors for use ofits network, but also to unfairly lower prices on the sale of electricity in thecompetitive (generating or supply) markets. As a result, a vertically-integratedcompany can effectively, and at the cost of potential competitors, maintainits market share and block development of competition in a formally openmarket. In this context, the idea of restructuring vertically-integrated incumbentsto remove monopoly from the potentially competitive activities seemed to bean obvious solution to the problems faced by the telecommunication and gasregulators attempting to control the anticompetitive practices of the privatizedincumbents. The concept of pro-competition restructuring was supplementedby two other elements that were supposed to improve development ofvigorous competition and effective regulation. The first element involvedfurther unbundling of activities leading to the separation of transmissionfrom distribution activities and separation of the network activities from tradeactivity (wholesale and retail). The second element of the restructuring referred to horizontal de-integrationwithin generation, trade, and distribution activities, leaving the transmissionactivity as a national monopoly. De-integration of generation and trade wasaimed at enhancing competition through the creation of a competitive structurefor both types of electricity markets. In turn, de-integration of distribution 5 The concept of cross-subsidy attracted the attention of many economists a long timebefore the liberalization processes started. See more on this with extensive list of publications:E Ralph, Cross-subsidy: A Novice’s Guide to the Arcane, Duke University, Durham NC 27706USA, 1992, paper available on the web. 6 In Polish that issue is discussed by: A.T. Szablewski, ‘Konsolidacja a konkurencja napolskim rynku energii elektrycznej’, (2002) 2–3 Gospodarka Narodowa.Vol. 2011, 4(4)

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208 ANDRZEJ T. SZABLEWSKIwas justified on regulatory grounds. Two arguments were provided here. Thefirst one indicated the advantages of transparency in cost calculations thatcould facilitate non-discriminatory access to the network. This argument alsoreferred to the unbundling of transmission. The second argument stressed thatthe existence of several distribution companies, each having monopoly powerin its own region, was conducive to implementation of incentive regulation inthe form of so-called ‘yardstick competition’7. This approach to the optimal structure for the electricity industry, basedon the fully vertically and horizontally de-integrated sector, led to the modelfor a stand-alone electricity company. Unlike the traditional model, the newmodel assumed that an electricity company could perform only one of four keytypes of activities. Justification of the new model included an assumption thattechnological change, including the development of computer and internettechnology, had significantly diminished economies of vertical integration andmade electricity generation and trade potentially competitive activities. Due tothe low transactions costs, the stand-alone generating and trading companieshad become a better – in terms of economic efficiency – alternative to thetraditional model for an integrated company8.3. Restructuring developments Though the rationality of the structural canon for electricity liberalizationwas not seriously questioned in the first stage of the reform programs’implementation, few countries decided to embark on a radical restructuringof their vertically- and horizontally-integrated incumbents9. Whereverthe governments began discussing the restructuring option as part of theliberalization reform package, the incumbents put up strong resistance thatsignificantly slowed, or even inhibited its implementation. The course of thede-integration process depended on the following factors: (i) the extent ofthe initial degree of vertical sector integration in a given country; (ii) theownership status of electricity companies; and (iii) the type of de-integrationstrategy chosen. 7 Yardstick competition involves use by a regulator of information from several firms todetermine the incentives for each firm. J. Sobel, ‘A Reexamination of yardstick competition’(1998) 8(1) Journal of Economics and Management Strategy. 8 For more on this see: R.J. Mitchels, ‘Vertical Integration: The economics that ElectricityForgot’ (2004) 17(10) The Electricity Journal, pp. 12–13. 9 See for example the restructuring plan for Enel in Italy: M. Giuletti, R. Sicca ‘Theliberalization of the internal market for electricity: what choices for Italy’ (1999) 8 UtilitiesPolicy. YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 209 As far as the first factor is concerned two traditional models of verticalintegration – the fully- and partially-integrated model – need mention. Thefully-integrated model involved a national monopoly company performing allvertically-related types of activities (from electricity generation to its supply).Breaking up such a company could theoretically lead to an ideal – in verticaland horizontal terms – structure for the electricity sector. According to theviews promoted at the initial stage of the sector’s liberalization, the splittingof a national incumbent was to result in the division of the electricity sector’sstructure into three separate sub-sectors – namely, generation, transmission,and distribution. The first sub-sector was to consist of a number of competingcompanies. The second was to operate as a single, nation-wide company,while the third sub-sector was also to consist of a number of companies, butthese companies would perform two activities – distribution and the supply ofelectricity to final consumers. The unbundling of the distribution companieswas scheduled to take place later and it was to complete the process ofshaping the electricity sector’s structure as a one based solely on stand-alonecompanies. Poland was one of the very few countries whose electricity sector wasstructured closely in line with this model. At the beginning of the 90s, thedomestic electricity sector that had operated as a nation-wide monopolystructure called Zjednoczenie, was disintegrated into three sub-sectors. Thesesub-sectors included more than 20 big generating companies, one nationaltransmission company, and 33 distribution companies. The disintegration,however, was not a result of a planned restructuring operation aimed atcreating conditions for developing competitive electricity markets. It wasrather an effect of the market transformation of the whole Polish economy.The transformation led to the collapse of many of the old corporate structures,including Zjednoczenie. This, in turn, inspired some experts to consider andundertake work on the concept of market-oriented reforms that would takeadvantage of such a favourable sector structure. The program of reformsthat followed was based on the assumption that supply sub-sector (which atthe time was non-existent) would naturally evolve as a result of a regulatoryframework that has to be developed in order to enable real competition inthe sale of electricity for final consumers10. The partially-integrated model embraced two types of companies. Thefirst type consisted of companies that combined generation and transmission 10 For more extensive discussion of the Polish program of reforms in the electricity sector in:A.T. Szablewski, ‘Koncepcja i programy wdrażania reform w energetyce polskiej’ [in:] P. Jasiński,A.T. Szablewski, G. Yarrow, Konkurencja i regulacja w przemyśle energetycznym. Brytyjskiedoświadczenia a polskie problemy, Polska Akademia Nauk, Instytut Nauk Ekonomicznych,ELIPSA, Warszawa, 1995.Vol. 2011, 4(4)

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210 ANDRZEJ T. SZABLEWSKIactivities. The second referred to distribution companies that, as mentionedabove, performed both network and trade activities. Depending on thecountry, the number of such vertically-integrated companies varied. However,distribution-supply companies were significantly more numerous than thegeneration-transmission companies. The restructuring of the first type of vertically-integrated electricity companyinvolved separation of generation from transmission accompanied by a furtherhorizontal de-monopolization of the generation sub-sector. The restructuringof the British generation and transmission company CEGB that preceded itsprivatization may serve as an example of that type of unbundling. It resultedin the creation of three generating companies and one national transmissionmonopoly company. On the distribution side of the British electricity sector,there was no need for companies’ horizontal restructuring as this sub-sectorhad already been divided into twelve companies. During their privatization,they maintained their vertical structure, i.e., distribution and retail activities.However, instead of their ownership separation, these companies were obligedto implement what was known as an accounting unbundling. It consisted ofperforming a separate calculation of distribution and supply costs. It is worth noting that in all cases of the successful electricity liberalization,the reform package included measures that ensured effective unbundling ofthe managing transmission activities. This conclusion is based on numerousempirical studies that analyzed various implications of transmissionunbundling11. Although the research results are mixed in respect to someunbundling implications, it is beyond a doubt that the effective unbundlingof transmission was a crucial factor that facilitated liberalization. In all thecountries that have succeeded in creating a competitive electricity market,the reform package included implementation of arrangements that ensuredindependent management of transmission activity. In turn, countries thatfailed to proceed fast with development of competitive electricity markets (likeGermany and France), have not had the effective unbundling regime in place. In the 1990s, wherever the process of forced vertical de-integration tookplace, it stopped with unbundling generation, transmission and distribution,leaving unbundling of the electricity trade from distribution for the future.New Zealand is the only case known to date of forced ownership unbundlingat the distribution level12. The unbundling was carried out in 1998 as the 11 A review of results of many research projects can be found in the paper by M. Pollitt,‘The arguments for and against ownership unbundling of energy transmission networks’ (2008)36 Energy Policy. 12 See: P. Nillesen, M. Pollitt, ‘Ownership unbundling in electricity distribution: empiricalevidence from New Zealand’ EPRG Working Paper in Economics 0836, 2008, paper available onthe web. The Authors point out that forced ownership unbundling at the distribution level has YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 211third phase of the reform process that started in 1987. The earlier phases hadprovided a set of conditions there were to establish a legal framework forthe operation of competitive and regulated electricity markets. However, thedisappointing results of the implemented legal measures – especially in termsof development of competition – led the government to decide to prohibitcompanies from being involved in a network (transmission or distribution) andto prohibit potentially competitive businesses (generation and supply) fromperforming both types of activities. In the case of distribution, the majority ofcompanies retained their distribution business and sold their supply business13. Not by chance, forced ownership unbundling occurred in the electricityindustries with the state-owned companies. This is because such an operationseems, at least theoretically, much easier to carry out. The splitting up ofa state-owned company prevents accusations of interference with privateproperty rights which may result in inhibiting the planned restructuring,or significant increase of the costs of legislation or procedures needed toimplement planned pro-competitive reorganizations of the private entity.Therefore, in the case of the network industries with state-owned incumbentcompanies, a key recommendation for governments preparing reforms aimedat their liberalization was to implement the pro-competitive structural changesprior to privatization (only if the latter was part of the reform program). However, in practice, the restructuring of a state-owned company was not soeasy to perform. As the British and Italian cases demonstrated, governmentsusually faced very strong resistance from the incumbent companies and theiremployees based on what seem to be rather obvious reasons. Generally, it wasa defence of their vested interests since the unreformed structure let them usemarket power to block new entries to formally open markets14. Usually, thesevested interests were masked by the more rational argument stressing that theunbundling operation had to involve significant transaction costs. These costsarise when the internal links within an integrated company are replaced bymarket transactions between unbundled companies. Though the argument seta solid base for attacking the unbundling concept, its supporters claimed thatthe decrease of costs due to a rapid development of competition in electricitygeneration and supply spurred by an unbundling operation far outweighedalso been imposed by law in the Netherlands in 2007. The unbundling is to be obligatory sinceJanuary 2011. More on the Netherlands case in: R. Kunneke, T. Fens, ‘Ownership unbundlingin electricity distribution: The case of the Netherlands’ (2007) 35(3) Energy Policy. 13 According to Nillesen and Pollitt, of the then 36 integrated distribution companies onlythree decided to continue operating as electricity supply companies, divesting their network(distribution) activity. Ibidem p. 18. 14 For more discussion of this argument see: K. Bobińska, ‘The Defense of Monopoly as aDeterminant of the Process of Transformation of State-owned Infrastructure Sectors in Poland’(2008) 1(1) Yearbook of Antitrust and Regulatory Studies.Vol. 2011, 4(4)

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212 ANDRZEJ T. SZABLEWSKIits disadvantages in the form of transaction costs. Therefore, they stronglyadvised the governments to precede privatization with the implementation ofpro-competitive restructuring15. However, this advice was rarely taken by thegovernments and shaped their structural policy. To complete the list of the methods through which unbundling has beenimplemented, voluntary ownership separation needs to be mentioned. It refersto the unbundling of distribution and commercial activities, since unbundlingat this level is a much less common practice than in the case of transmission16.At a significant scale, voluntary separation took place in the UK as well asin certain other countries like the US, where one of the most developed andsuccessful competitive electricity markets in the world operates in Texas. When– after a few years of the Texas wholesale competitive market operation – retailcompetition was introduces in 2002, two of the three largest incumbent utilitiesdecided to voluntarily divest their competitive operations, i.e., generation andretail service, and concentrate exclusively on regulated transmission as well asdistribution as a single company17.4. EU unbundling initiatives The unbundling concept was strongly promoted by the EuropeanCommission during a 7 year-long process of negotiation the first ElectricityLiberalization Directive18 (the Directive). It was to provide a suitable legalframework that would force effective and coordinated implementation ofthe liberalization programs in the Member States. However, because ofthe strong opposition of some Member States that were generally reluctanttoward electricity liberalization, most provisions of the Directive were a resultof an unsatisfactory compromise that made its adoption in 1996 a symbolicrather than significant event19. A good example of such a compromise was 15 The importance of strong governmental determination for the success of electricity sectorliberalization was underlined many times. M.B. Rosenzweig, C. Pabon-Agueldo, ‘Power SectorReform: Is there a Road Forward?’ (2006) 19(6) The Electricity Journal. 16 A review of transmission unbundling status in the European countries is provided by:R. Haas, J-M, Glachant, N. Keseric, Y. Perez, ‘Competition in the Continental EuropeanElectricity Market; Despair or Work in Progress’ [in:] F.P. Sioshansi, W. Pfaffenberger (eds),Electricity Market Reform. An International Perspective, Elsvier, 2006, p. 276. 17 See P. Adib, J. Zarnikau, ‘Texas: The Most Robust Competitive market in North America’[in:] F.P. Sioshansi W. Pfaffenberger (eds), Electricity Market Reform…, p. 392. 18 Directive 96/92/EC of the European Parliament and of Council of 19 December 1996concerning common rules for the internal market in electricity, OJ [2007] L 27/20. 19 L. Hancher, ‘Slow and not so sure: Europe’s long march to electricity liberalization’,(1997) 10(9) The Electricity Journal. YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 213an unbundling requirement that took the weakest form of management andaccounting. In practical terms, the Directive required vertically-integratedelectricity companies to carry out their activities (generation, transmission, anddistribution) by separately managed units that were also obliged to produceseparate sets of accounting. Therefore, it is not surprising that the Directive was not a driving forcebehind electricity liberalization in some European countries. According to theCommission and the energy traders20, one of the most important reasons forthe very unsatisfactory progress in opening most of the domestic electricitymarkets was the existence of persistent anticompetitive practices amongvertically-integrated companies. By setting discriminatory terms of use fortransmission and distribution lines, such companies blocked the access oftheir potential competitors to electricity markets. Further strengthening of theunbundling regime for vertically-integrated companies had therefore becomea priority goal of the Commission determined in speeding up real progress inelectricity liberalization in the EU. During the drafting stage of the next Liberalization Directive21, theCommission succeeded in getting approval for a more advanced form of theunbundling requirement imposed on the vertically-integrated companies.This involved the obligation to establish system operators – the TransmissionSystem Operator (TSO) and Distribution System Operator (DSO) respectively– as subsidiaries of such vertically-integrated companies (i.e., their parentcompanies) that were to operate on the basis of the ‘legal unbundling regime’.This regime included a list of detailed requirements that were to ensure thatthose persons responsible for network management would have a necessarydegree of independence from the owners of the network22. For example, oneof these requirements referred to salary rules of the TSO/DSO staff that hadto depend exclusively on the performance of the network business and beestablished on the basis of pre-fixed elements. The other one provided thatthe staff were not allowed to undertake tasks referring to other non-network-related activities within the parent company. It is worth emphasizing that in the comments made in the documentdiscussing the details of the unbundling regime, a vertically-integrated company 20 See: Unbundling as a crucial factor in the completion of European Electricity and GasMarket liberalization, Position Paper, EFET, September 2000. 21 Directive 2003/54/EC of the European Parliament and of Council of 26 June 2003concerning common rules for the internal market in electricity and repealing Directive 96/92/EC, OJ [2003] L 176/37. 22 A detailed description of this regime was provided in: An detailed description of thisregime was provided in: The Unbundling Regime, Note Of DG Energy &Transport On Directives2003/54 and 2003/55/EC On The Internal Market In Electricity and Natural Gas.Vol. 2011, 4(4)

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214 ANDRZEJ T. SZABLEWSKIwas defined as a company that performs “at least one of the functions oftransmission or distribution and at least one of the functions of generationor supply of electricity”23. Therefore, the unbundling regime did not applyto generation and supply activities. In other words, from the EU legislationperspective, both activities were allowed to be performed within one company. Despite more demanding unbundling requirements contained in thesecond Liberalization Directive, the reports of the Commission inquiry intothe functioning of the EU electricity markets that were regularly publishedindicated that vertically-integrated companies were still able to continueblocking access to their transmission and distribution grids and prevent orhinder new entry to the electricity markets. Therefore, in the opinion of theEU Commission, introduction of further measures addressing the problemof effective unbundling was necessary in order to deliver non-discriminatoryaccess to electricity networks and thereby speed up the process of internalelectricity market completion. Preparing its Third Energy Package24, theCommission’s preferred option was ownership unbundling. However, because the Commission anticipated problems with gettingapproval for this proposal from certain countries rather reluctant to implementmore aggressive pro-liberalization measures, its proposal was restricted toimposing stricter unbundling requirement only with respect to transmissionactivity, leaving unbundling at the distribution level for further discussionand decisions25. In addition, in the Third Package put forward on September19, 2007, the Commission added a second, compromised option. It assumedretaining by generating companies of their network assets, but it deprivedthem of the ongoing, operating management of these assets. The crucialpoint of this option was transfer of responsibility for network managementthat involved daily management and also the right to make commercial andinvestment decisions to a special company, the Independent System Operator 23 Ibidem, p. 5. 24 The Package includes 2 Directives and 3 Regulations: Directive 2009/72 EC of 13 July2009 concerning common rules for the internal market in electricity and repealing Directive2003/54/EC; Directive 2009/73/EC 13 July 2009 concerning common rules for the internalmarket in natural gas and repealing Directive 2003/55/EC; Regulation (EC) No 713/2009 of 13July 2009 establishing an Agency for the Cooperation of Energy Regulators; Regulation (EC)No 714/2009 of 13 July 2009 on conditions for access to the network for cross-border exchangesin electricity and repealing Regulation (EC) No 1228/2003; Regulation (EC) No 715/2009 of13 July 2009 on conditions for access to the natural gas transmission networks and repealingRegulation (EC) No 1775/2005. 25 As it was explained by the Commission, because ‘…of the recent entry into force of thelast liberalization date in a number of states, it would seem to be disproportionate to go a stepfurther in forcing unbundling in this activity’ (distribution). Impact Assessment, AccompanyingReport, European Commission, Brussels, 2007, p. 4. YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 215(ISO). This company was to be designated by national governments with theCommission’s prior approval and be provided with appropriate arrangementsensuring a sufficient level for its independence. This compromise option turned out to be unacceptable, especially forFrance and Germany. Both countries had very powerful vertically-integratedcompanies that strongly opposed the concept of transferring all decisionsconcerning management of transmission activity to an ISO. Under pressure ofthese countries, a third option for Independent Transmission Operator (ITO)was introduced to the final version of the Third Package. This option wassimilar to the ISO option in allowing integrated companies to retain ownershipof network assets, but in contrast to the ISO, a newly established company(ITO) would be responsible only for daily network management. Although theintegrated companies were left to make commercial and investment decisions,the ITO option included a list of 5 institutional arrangements that were toensure independent management of the grids, and especially to prevent theITO from discriminating against suppliers applying for access to the grid. The Third Package, including these three unbundling options, was adoptedfinally by the Council on June 25, 2009. To strengthen its impact on the paceof the European electricity market liberalization, some other importantprovisions, especially concerning the regulatory framework, have beenincluded. They provide more power for national sector regulators and createa new European agency with the task of overseeing and improving cross-border regulation for electricity and gas transmission between the MemberStates. In addition, the earlier voluntary cooperation of national TSOs is to beformalized through the establishment of a new body – the European Networkfor Transmission System Operators. Its purpose is to harmonize standards forgrid access as well as coordinate and ensure proper network planning andinvestment to prevent blackouts.5. The first signs of crisis in the restructuring model The beginning of the current decade brought a visible change to the overallliberalization climate. Visible in some countries, the decrease in support forthe radical actions that were intended to introduce competitive electricitymarkets was followed by, inter alia, a change in attitude towards the sector’sstructure. The change was a result of a number of factors, in particular theEnron bankruptcy, the Californian crisis, the British Energy problems, andthe return to the vertical structure – although in a modified form –that tookplace in the British electricity sector. The importance of these events lies inVol. 2011, 4(4)

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216 ANDRZEJ T. SZABLEWSKIthe fact that they inspired intensive development of research on the specificfeatures of the electricity markets which previously had been overlooked orundervalued by promoters of electricity liberalization. The results of the research demonstrated a growing need for revaluationof the issue of vertical integration in the electricity sector, and thus also theearlier discussed structure model for electricity liberalization. It is thereforeworth taking a closer look at these cases. The Enron insolvency, the Californiancrisis, and the British Energy problems are interesting in that they show realthreats faced by stand-alone electricity companies operating in competitivewholesale and retail electricity markets. In turn, the British case of backwardvertical integration shows how companies that are free to decide about theirstructure react to the upcoming full opening of the electricity market, i.e.,the time when all customers, including households, can choose their supplier. The collapse of Enron is usually considered in a broader context that goesbeyond the normal (for the market economy) case of corporate bankruptcy.Because of the size of Enron26 and the fact that its insolvency to a great extentwas of a criminal nature, some observers saw it not only as a problem oflosing trust in capital markets, but even as a reason to question free marketsat all27. On the other hand, sceptics of radical electricity liberalization treatedit as proof of the defeat of the whole idea of energy liberalization28. Even ifthis opinion was exaggerated, certain factors indicate that Enron’s fall andthe Californian crisis have significantly contributed to weakening support forelectricity liberalization among US regulators, policy makers, experts, andpublic opinion. Enron’s case should be considered from the perspective of the structuralaspect of the liberalization concept. In this respect, at least two factors seemimportant. Firstly, in the US, Enron was the most recognizable product ofliberalization and an example of an energy company which, without havingmeaningful generation or network assets, could make a huge financial successin a very short time29 by focusing its activity on competitive gas and electricitywholesale markets. Secondly, Fortune magazine ranked Enron as the mostinnovative company for six years in a row for launching a novel businessin energy (electricity and gas) trading. It was therefore no surprise that its 26 Enron was the second largest corporation to have ever gone bankrupt. 27 See Editorial Board, ‘Enron’s Sins’, (2002) Wall Street Journal, January 12. 28 This opinion was expressed for example by J. Stiglitz The Roaring Nineties: A New Historyof the World’s Most Prosperous Decade, 2003, ch. 10. In-depth discussion of Enron’s Case ispresented by: J.L. Weaver, ‘Can Energy Markets Be Trusted? The Effect of the Rise and Fallof Enron on Energy Markets’ 2004 Houston Business and Tax Law Journal. 29 In December 2001 – the year when Enron was listed as the seventh largest company inthe Fortune 500 – it declared insolvency. YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 217bankruptcy significantly weakened belief in the workability of the model ofa stand-alone electricity company focused on wholesale and retail activities. On the other hand, the British Energy case signalled the poor workabilityof this model with respect to electricity generation. Providing 20% of Britain’stotal electricity supply, British Energy was the largest electricity producer andthe only one that had not been involved in the process of vertical reintegrationof generation and distribution/supply activities. Unlike the other reintegratedBritish electricity generators, it was unable to compete in the fully liberalizeddomestic electricity market. In 2002, its financial condition was so grave that itwas close to becoming insolvent. The company was rescued by the governmentwhich provided substantial financial aid and therefore kept British Energyoperational30. However the collapse of Enron was not as important – at least in the US –as the Californian crisis, especially in terms of its impact on the increasinglycritical attitude towards radical liberalization, in particular that in line with theBritish patterns31. The Californian program of considerable restructuring andthe launch in 1998 of competitive generation, wholesale and retail marketswere to significantly improve companies’ efficiency, but mostly to decreaseelectricity prices for final consumers. However, only two years after the newmarket mechanisms were set in motion, it became clear they had not achievedthe above goals. The most undesired results of the Californian reforms were:an explosion of wholesale electricity prices (within 14 months average pricesincreased tenfold), their very high volatility, long lasting supply shortages,and unprecedented insolvencies of the two largest electricity state companies. Without focusing closely on the factors that triggered the collapse ofCalifornia’s electricity reform program32, it is worth taking a closer look atthe role of the structural factor. This was emphasized in most of the seriousanalyses of the Californian electricity reform failure as a factor that significantlycontributed to such failure, but not always was it treated as an argumentindicating an important weakness of the vertical unbundling concept. Toadvance this argument, two pivotal components of the Californian electricityliberalization reform package should be mentioned. 30 M. Zakary, British government saves British Energy from bankruptcy, available at: http://www.bellona.org/english_import_area/energy/nuclear/26199. 31 A lot of publications indicate the negative impact of that crisis on the course ofliberalization of the US electricity sector: S.A. Blumsack, J. Apt, L.B. Lave, ‘Lessons from theFailure of U.S. Electricity Restructuring’ (2006) 19(2) The Electricity Journal or T.M. Lenard,‘Electricity “Restructuring”: What Went Wrong’ (2005) 18(6) The Electricity Journal. 32 There are many references to the reasons and consequences of California’s electricitycrisis on the course of liberalization of the US electricity sector: S.A. Blumsack, J. Apt, L. B.Lave, ‘Lessons from the Failure…’; T.M. Lenard, ‘Electricity “Restructuring”…’Vol. 2011, 4(4)

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218 ANDRZEJ T. SZABLEWSKI The first component referred to the forced ownership unbundlingrequirement. Two of the three largest Californian electricity companies wereordered to divest – as specified by law – part of their generating capacity.They were also strongly encouraged by regulatory measures to divest allother capacity, as well. As a result, they were left with generating capacitymuch below the level needed to fulfill their duty as a default supplier ofelectricity33. The second factor was the adoption of a new model for tradingarrangements, based on the assumption that utilities supplying electricity tofinal consumers would be buying electricity only from the just established,competitive spot wholesale market. This model also forbade utilities frombuying electricity for its resale to consumers directly from generators on thebasis of long purchase contracts. Since such contracts normally serve as anefficient measure protecting utilities from the very high – by nature – volatilityof short-term wholesale electricity prices, their lack made utilities susceptibleto the monopolistic manipulation of the generators. This susceptibility wassignificantly strengthened by another component of the trading arrangements’model, i.e., a price cap imposed on retail prices that made it impossible for theutilities to pass on the fast rising costs of their wholesale electricity purchasesto final consumers. Examining the causes of the Californian crisis, P. Joskow, one of the mostdistinguished researchers and experts on energy markets, noted the unusualattributes of electricity that make design of a well-functioning competitiveelectricity market a very difficult task34. His crucial point was that spotcompetitive electricity markets work well where supplies are abundant dueto adequate capacity and reliable generation and network infrastructure35.However, when supplies become tight and demand is not elastic, prices canexplode, which is exactly what happened in California. Concluding his analysis,Joskow focused on the structure of the trading arrangements introduced in 33 This is a supplier obliged to sell electricity at regulated prices to customers who do notwant to change supplier. 34 P.L. Joskow, ‘California’s Electricity Crisis’ 17(3) Oxford Review of Economic Policy. Thereis a growing literature on the peculiarities of electricity competitive markets and their implicationsfor the structural model of an electricity company D. Newbery, Regulatory Challenges to EuropeanElectricity Liberalization, DAE Working Paper WP 0230, 2002, p. 13 or D.W Bunn, ‘InstitutionalIntent and Strategic Evolution Electricity Markets’ [in:] Complex Electricity Markets (Editor:W. Mielczarski), Series: The European Power Supply Industry, Wyd. Instytut ElektroenergetykiPolitechniki Łódzkiej I Stowarzyszenie Elektryków Polskich, Oddział Łódzki, Łódź 2006. 35 This point has also been made in many other publications. See for example: D. Newbery,‘Problems of liberalizing the electricity industry’, (2002) European Economic Review 46.In Polish, a broad review of views on implications of electricity competitive markets provides:A.T. Szablewski, Liberalizacja sektora elektroenergetycznego a bezpieczeństwo dostaw. Wnioski dlapolityki energetycznej i regulacyjnej, forthcoming. YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 219the Californian market as one of the main reasons for the troubles in theirfunctioning. According to Joskow, solving problems generated by volatile and veryexcessive spot prices for electricity needs to use long-term, fixed-pricecontracts negotiated well in advance of spot market crises. Therefore, a keyweakness of this structure was prohibition imposed on vertically-restructureddistribution companies to enter into long-term fixed-price electricity purchasecontracts that could stabilize electricity prices. However, a further questionarises – namely, if such long contracts are a viable option in markets whereretail competition is allowed. This question became an important subject of discussion in the UK just whenplans for the Californian package of reforms involving the strict unbundling ofdistribution and supply business were being prepared. Due to the approachingdate on the full opening of the British retail electricity market (1998), it wasbecoming obvious that distribution companies would be much less willing toenter into long-term contracts with generators. The reason for this was thelack of certainty as to whether customers would be willing to purchase suchcontracted electricity if they had a choice to select their own supplier. This, inturn, could create serious problems for generators, as without such contractsthey would face difficulties in attracting new capital needed to finance newgeneration facility36. One obvious answer to the above question was vertical integration initiatedby the generators and, later, also distribution/supply companies. Initially, thegenerators’ pressure to begin vertical consolidation was strongly resisted bythe government, the regulator, and Monopoly and Mergers Commission(MMS) because of its potentially anticompetitive effects. However, with timeresistance weakened and a new approach to vertical integration prevailed inthe governmental and MMC circles. This approach was based on the argumentthat competition in generation had developed and the stable competitivestructure of generation and supply markets gave little scope to use verticallinkages to exploit customers. In a very short time, vertical integration again became a standard modelfor the largest British electricity companies, although with some importantdifferences in comparison with the earlier recommended model structurebased on full ownership unbundling. The process of integration took two forms,the first being more traditional with integration of generation, distribution,and supply (retail) businesses and the second being more innovative withintegration of merely generation and supply businesses. Many factors justifythe view that the latter model of vertical integration may become the leading 36 For more on this see: D. Helm, Energy, the State, and the Market. British Energy Policysince 1979, Revised Edition, Oxford University Press 2003, chapter 12.Vol. 2011, 4(4)

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220 ANDRZEJ T. SZABLEWSKImodel in the future. This includes the increasing pressure of the EuropeanCommission on further deepening of separation of supply from distributionactivities and the fact that other countries with mature liberalization in theelectricity sector also follow that trend.376. Concluding remarks The increasing intensity of the consolidation processes in the first yearsof the new century seems to indicate that the above outlined cases were thefirst symptoms of the non-workability of the ideal structural model that wasrecommended as a part of the electricity liberalization reform package. Thismodel was formed in the early days of network industries’ liberalization andit predicted that electricity sectors would be evolving into a structure witha large number of separate generating and wholesale/retail supply companiesresponsive only to market forces. However, the currently emerging verticalmodel for electricity companies is quite different from this initial model.Moreover, many in-depth economic studies on the structural dimensionof electricity liberalization re-examine arguments for and against verticalintegration, and their conclusions tend to underline the advantages ofa balanced mixture of vertical integration and liberalized markets38. In other words, the structural canon (or, as some authors call it, the industrialreference model or industrial paradigm)39 for electricity have changed. Ithas shifted from a preference for vertical disintegration between generationand trading activities towards a preference for vertical reintegration of theseactivities within one company. This shift represents a more serious change toenergy policy priorities. Liberalization was a response to the growing need tomake electricity companies more efficient in terms of costs. Through lowerprices liberalization was to pass the advantages of increased cost efficiencyto the final electricity consumers. To achieve this task, conditions for theeffective operation of competitive markets had to be created. This requiredan appropriate legal and regulatory framework, pro-competitive restructuring 37 A good example is again New Zealand. Shortly after the full vertical unbundling ofelectricity companies and imposition on network owners a legal prohibition to enter competitiveactivities, there was a rapid realignment of the sector with energy retail businesses being quicklyacquired by generators. 38 Intensive research in this subject in presented in: H-P. Chao, S. Oren, R. Wilson,‘Revaluation of Vertical Integration and Unbundling in Restructured Electricity Markets’[in:] F.P. Sioshansi, (ed), Competitive Electricity Markets: Design, Implementation, Performance,Elsvier, 2008. 39 R. Haas, J.-M. Glachant, N. Keseric, Y. Perez, Competition in the Continental…, p. 286. YEARBOOK of ANTITRUST and REGULATORY STUDIES

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THE NEED FOR REVALUATION OF THE MODEL STRUCTURE… 221of the incumbents, as well as active regulation to promote competition in orderto increase the number of generating and supplying companies. The development of competitive and regulated electricity markets hasresulted in a crucial reallocation of bearing economic risk. In the traditionalmodel of regulated, vertically-integrated electricity companies, the whole riskwas passed to the final consumers. Due to such risk allocation, the regulatedutilities were assured of full recovery of prudently incurred investmentsand expenses, including the cost of capital. These regulatory arrangements,in turn, would facilitate them access to cheap capital necessary to financecostly generation and network investments. The introduction of competitiveelectricity markets (regulated through quasi-market incentives) reversed thedirection of bearing risk. Shifting risk to the electricity companies led toa significant increase of the cost of capital and made it much more difficultfor them to arrange financing of their investments. This was not a problem in the first years of liberalization since the electricitysectors inherited a significant excess of generation and network capacity.However, when, as a result of investment shortage, this began to diminish,a traditional priority of energy policy (i.e. ensuring security of electricity supply)was back in the game. The cost of capital and easy access to capital againbecame key energy policy and regulatory issues. The solution to those issuesinvolves a compromise between generating market-based incentives to reducecompanies’ operating costs and incentives to increase investments in electricitygeneration, transmission, and distribution. The central part of this compromiseseems to be a structural change of the model for electricity liberalization. Theemerging model involves the vertical integration of generation and supply andallows more horizontal concentration of competitive electricity markets. From this perspective, monitoring the structural changes of the competitiveelectricity markets becomes of critical importance. This leads to anothercontroversial issue – namely, the division of responsibility for competitionpolicy in the electricity sector between specialized sector regulatory agenciesand competition authorities. In other words, this is a question as to whetherfinding an appropriate level of vertical and horizontal integration in theelectricity markets requires a much deeper knowledge of electricity marketsand therefore should not be subjected to the general competition law enforcedby the competition authorities40. 40 Contrary views on this subject are presented in: D. Newbery, The Relationship BetweenRegulation and Competition Policy for Network Industries, CWPE 0631 and EPRG 0611, March2006 and M. Pollitt, The Future of Electricity (and gas) Regulation, CWPE 0811 and EPRG0819, May, 2008.Vol. 2011, 4(4)